This guide explains what subordinated debt is. It also explains the relationship that subordinated debt has to senior debt and equity financing in terms of liquidity position in the capital stack and the corresponding risk to subordinated debt investors. Here are some key takeaways about subordinated debt:
Subordinated debt is a term used to describe loans that are paid back after all other corporate debt has been repaid. In other words, subordinated debt has a lower liquidity position than senior debt in the capital stack.
This makes subordinated debt riskier than senior debt as those senior debt investors are paid back first in the event of a bankruptcy, default, or sale.
Generally subordinated debt is used by larger corporations and is lent to businesses with proven track records. Subordinated debt is a type of unsecured loan, meaning that the borrower doesn’t put up collateral against the loan.
Subordinated debt is considered a liability (like other debt) and is found on a company’s balance sheet, listed as a long-term liability. On a balance sheet, current liabilities would be listed first. Current liabilities are loans that are to be paid back within 12 months. Long-term liabilities are loans that have a lifespan of longer than a year. Of the long-term liabilities that a business has, senior debt is listed first, and then subordinated debt is listed in order of payment priority.
Subordinated debt can come in multiple forms including, mezzanine debt, high yield bonds, PIK notes, and vendor notes.
Mezzanine debt is a type of financing designed to bridge the gap between equity financing and senior debt (like traditional term loans). Mezzanine debt may or may not come with warrants attached. If there are warrants, mezzanine debt allows investors (the issuers of the debt) the option to convert their loan to equity as per the agreement. Mezzanine debt can be structured as either preferred stock or as unsecured debt. Mezzanine debt, like all subordinated debt is riskier than senior debt. To offset this risk, mezzanine debt usually pays 12-20 percent interest as compared to around 10 percent or less for senior debt. So, there is more risk inherent in the lower liquidity position, but a higher upside return is possible for mezzanine debt investors.
High-yield bonds are bonds that carry a higher interest rate due to having a lower credit rating than investment-grade bonds. They are also sometimes called “junk bonds.” High-yield bonds pay higher yields than investment-grade bonds do because they are more likely to default. Rating services such as S&P and Moody’s measure the riskiness and quality of bonds and provide investors with credit ratings. High yield bonds are rated below BBB by S&P and Baa3 by Moody’s. To learn more about how corporations raise capital with bonds, we recommend our guide: Investment Banking Underwriting Services.
PIK notes are another type of subordinated debt financing. The term “PIK” stands for payment-in-kind. PIK notes are loans where the borrower is allowed to make repayments in other forms than cash. PIK loan agreements can include shares of stock or equity discounts. They allow the business to borrow money from a lender without the burden of needing to make regular cash payments on the loan. Though these loans can unburden a business from making regular cash payments, the business will have higher interest that can be added to the principal balance or dilute equity. Private equity firms often use PIK notes in leveraged buyouts.
Last, we have vendor notes. Vendor notes result from an arrangement where a vendor lends another business money in order to buy its products. The term “vendor financing” refers to the arrangement of a vendor lending to a customer (business), and a “vendor note” is what results from this arrangement. Vendor notes are a form of subordinated debt, found on a company’s balance sheet. A business could use vendor notes as a way to buy more inventory from a supplier that it can’t afford to pay for in cash, upfront. Vendor notes are normally used when a business is unable to use senior debt to finance expansion and needs money to buy inventory. To learn more about vendor notes, we recommend our guide: Vendor Financing.